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Michael Fowlkes' Analyst Insights

April 28, 2014 - YUM! Brands Serves Up Better than Expected Earnings

Last week, the restaurant sector came into focus, with several major fast food chains reporting their quarterly results. Among the list of companies reporting was Yum! Brands, which posted better than expected earnings for its first quarter.

Yum! Brands is an interesting restaurant stock to watch because it operates such a wide variety of restaurant chains, which include Kentucky Fried Chicken, Pizza Hut, and Taco Bell. Since Yum! Has three major chains under its roof, it provides a much clearer picture of the overall sector than companies with just one brand.

At first glance, the report looks great. First quarter earnings of $0.87 per share came in higher than the $0.84 consensus estimate, however the report was light on revenues. The company had Q1 revenues of $2.72 billion, a bit shy of the $2.79 billion consensus estimate.

As is the case with most restaurants, Yum! Brands has a lot riding on growing its Chinese business, were it performed OK just the quarter, but not as good as Wall Street forecast. China accounts for around 50% of the company's total revenues, so it is very important that operations move in the right direction in the nation. Its same-store sales growth in China was 9%, which is impressive, but under expectations for 9.2%. The company plans to open 700 new locations in China this year alone.

The growth in China is encouraging, especially in light of the poultry supply problems the company encountered last year, which certainly factored into the company's 20% same store sales decline during the same period last year. For now it appears as though China is back on track for the company, but there could be trouble on the horizon has Avian Flu broke out in early 2014 in the country and could adversely impact sales in the upcoming quarters.

While growth in China remains pretty much on target, sales in the U.S. are sluggish, and total worldwide sales were up just 4% during the quarter. Kentucky Fried Chicken sales were up 3% internationally, but were down 3% in the America. Pizza Hut's international sales were up 8%, while U.S. sales were down by 3%. Taco Bell fared a bit better in the U.S., but still had sales drop 1% in the quarter.

Immediately after the company's earnings release the stock jumped higher, but those gains were quickly erased, and the stock actually closed down 0.9% on the day following the report. The good news for investors is that the stock regained its footing, and is still trading just a bit higher than where it was prior to the earnings release.

I like the company, and believe that its growth in China is going to help keep momentum in the stock. However, China plays such a pivotal role to the company's total health that we have to be worried about possible sales disruptions should more cases of Avian Flu come to light. With multiple cases already reported this year, it could spread at any time, and that would put Kentucky Fried Chicken sales in serious jeopardy.

With the potential for another Avian Flu outbreak, I would advise hedging any position on YUM at the current time. You can use options to set up a hedged trade on the stock that has a nice target return, but also provides a safe level of downside protection should the stock head in the wrong direction.

A nice hedged trade on YUM would be the July 65/67.50 bull-put credit spread. In order to set up this trade, you would sell the July 67.50 put while buying the same number of July 65 puts for a credit of 20 cents. This trade has a target return of 8.7%, which is 37.3% on an annualized basis (for comparison purposes only). YUM is currently trading at $77.53, so the trade has a comfortable 12.7% downside protection. As long as the stock trades higher, flat or loses less than 12.7% before expiration you will book the total 8.7% return.